On Thursday the ECB released its plan for QE for 2018. It was exactly as expected as the bond buying was cut in half to 30 billion euros per month for 9 months and then lowered to nothing over the next 3 months. Draghi made some missteps this year with the way he handled guidance, but the lead up to this announcement and the decision were perfect. The best thing a central banker can do is deliver exactly what the market wants. It instills trust. If there was a surprise, the market wouldn’t know how to price future guidance because it wouldn’t trust his words. The table below breaks down the outlook for 2018. 9 months of 30 billion euros is 270 billion. The total is 330 billion euros so that means there will be 60 billion in purchases over the final 3 months. That’s the end of the program until another slowdown causes a need for more stimulus.
Personally, I think this process is being drawn out because the ECB never wants to stop buying bonds to help support the economy. The longer it goes, the greater chance a recession occurs before it’s over. The ECB clearly isn’t worried about interest rates being below zero before a recession because guidance is for no increases until 2019 at the earliest. Another theory is that the ECB hasn’t ended the program because inflation goals haven’t been met. My counter point to that theory is that the ECB shouldn’t taper QE at all if it thinks inflation won’t meet its goals in the next few years.
It’s also worth noting that the ECB clearly doesn’t care about the current rule which limits purchases to another 200 billion euros since this plan calls for another 330 billion euros in bond buying. Draghi didn’t explicitly rule out amending the rule which limits purchases to 33% of the European bonds. Maybe he didn’t want to make that announcement on Thursday that the rule was being amended, but it seems to me like a foregone conclusion.
The ratio of the total APP to the PSPP is similar to past purchases. It appears there was an equal decline of all the line items within the purchase program. This makes sense because the program will be ending in 12 months. That type of tapering hadn’t been tried before, so why start changing it right before the end?
European stocks were up across the board on Thursday. This is great news because the continent is in the sweet spot of seeing accelerated growth combined with a dovish central bank. A negative interest rate policy many years into an expansion runs the risk of eliminating that tool to fight the next recession, but ECB policymakers must figure they can use QE to fight any economic weakness. Many skeptics and market bears think the central banks will buy up all assets in the next recession. This policy of negative rates into 2019 doesn’t quell those concerns. The central banks have gotten lucky that there hasn’t been a global recession since the financial crisis. Some argue they were active in preventing a recession in 2016 as QE exploded to the largest ever when you combine all the major central banks’ balance sheets.
The run of excellent returns and low volatility in global equity markets continued as the DAX was up 1.39%, the CAC was up 1.50%, and the STOXX600 was up 1.07%.. The euro declined versus the dollar; it fell from 1.1813 to 1.1649. The ECB appears to be comfortable with having a much more dovish position than the Fed. Both are heading in the same direction, but there could be a point in 2019 where the Fed funds rate is 2% while the ECB deposit rate is still at -0.40%. The Fed could spur a recession by raising rates more than 3 times next year which would be problematic for Europe as it still has crisis level policies in place.
The 2018 Fed policy is dependent on who President Trump picks as chair and vice chair. He could pick Taylor as chair and Warsh as vice chair. That would bring about a new era of hawkishness. The ECB might need to alter policy in response to the Fed. It’s also worth noting a new ECB President will take the helm in 2019. Currently the odds are showing Powell with a 57% chance and Taylor with a 31% chance of being the next Fed chair. The decision will be announced in the next 6 days according to reports. However, this decision has already been delayed, so it’s not out of the realm of possibilities that it comes a few weeks later. Picking Taylor or delaying the pick will cause a selloff in equities.
The final point we need to discuss about the ECB’s policy announcement is that Draghi said the ECB will reinvest the principal investment from the maturing bonds for an extended period after the end of the bond buying program. This is a hawkish statement, in my opinion, because it implies that the ECB will eventually wind down the balance sheet in the next few years if everything goes according to plan. We’re looking at QE ending in late 2018, rates being raised starting sometime in late 2019 or early 2020, and the balance sheet unwind starting possibly in 2021. If the unwind starts in 2021, it means the ECB is 4 years behind the Fed. The Fed’s unwind will probably be over by then. We will get a preview of whether this policy guidance is possible when we see the market’s reaction to the taper in early 2018. I expect inflation to increase without the QE because the economy is improving. I also expect volatility to pick up in equities.
Conclusion
I think this week is the most critical one of the entire year because of earnings, the new iPhone pre-order period starting, the Fed pick, and the ECB QE announcement. It looks like the Fed pick will end up being next week. The QE decision was made without a hitch as Draghi delivered what was expected. This sent risky assets souring. The party isn’t ending in the near-term.
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